–First off, yesterday’s DR finished with the promise that today’s would be about the Reserve Bank of Australia…its history…its mandate…and its similarities and differences to the U.S. Federal Reserve. It will have to wait until next week.
–The more we read yesterday, the more we realised it would take more than the usual superficial treatment we give such subjects in the Markets and Money. And with today’s announcement that the Board will have two new directors, there is more grist for the mill. But don’t worry! It’s too important a story not to be told, so we’ll keep working on it.
–It’s worth working on because the story contains the answers to some key investment questions…like what happens to the Aussie dollar in a U.S. dollar crash…what happens to Aussie interest rates next…and whether the RBA can or would print money like the Fed if (when) Australia has its next financial crisis.
–In the meantime, we’re going to ignore all the price action in the market and focus on two other stories; the banking sector’s denial of financial reality and Ross Garnaut’s academic understanding of innovation and knowledge. We’ll begin with the banks.
–The global banking sector—Australia included—is generally in a state of denial about the future. Major banking reforms (Basel III) came out of the last crisis to prevent the same problem from happening again. The main problem was too much leverage. Banks built huge pyramids of assets on a tiny little base of liquid capital. When asset values fell quickly, capital was wiped out and had to be replaced (either by private investors or mostly by the government and central banks).
–What compounded the problem is that bank’s financed long-term lending (expansion of assets on the balance sheet) with short-term borrowing (expansion of liabilities). But while the assets and the liabilities might be matched in terms of size, they weren’t matched in terms of duration.
–Without getting too technical, the “duration gap” is a measure of the risk associated with having mismatched liabilities and assets. That risk is mostly from interest rates. For example, if you’ve borrowed short and lent long and interest rates rise, it means your borrowing costs go up right away while the value of your long-term assets goes down (interest rates tending to rise with inflation).
–Double plus un-good.
–Of course the main problem is that in the last 30 years banking has become an incredibly profitable business, especially for the men who run the banks. Expanding the balance sheet (more loans) is the way to grow earnings. And most bank managers seemed happy to do this in the credit boom, especially since the global cost of capital was absurdly (and artifically) cheap and all asset markets everywhere were going up.
–No one (except Dr. Kurt Richebacher) seemed to recognise it as a worldwide credit-fuelled asset bubble. And when banks finally realised what had really happened (what they in part created), they were caught with falling assets and an urgent need to raise new capital. Which brings us to today.
–Europe’s banks alone will have to raise as much as $3.2 trillion in order to meet the new liquidity requirements of the Basel III bank regulations. “Basel III, due to be implemented in 2019, proposes requiring banks to hold enough cash or liquid assets to meet liabilities for a year,” Bloomberg reports. “The aim is to wean banks off the short-term funding from other lenders that dried up during the crisis and sent Lehman Brothers Holding Inc. into bankruptcy.”
–You wouldn’t expect banks to like any kind of rule that limits their profitability. But that’s where all this, if left unchanged, is headed. Another set of regulations—the European Union’s Solvency II regulations (which are due to come into effect in two years)—would make it more difficult for insurance companies to buy long-term bank debt. Banks would be unable t match long-term loans with long-term bonds.
–Simon Willis from Daniel Stewart Securities Plc. in London says if banks can’t sell corporate bonds to insurers, they will have to borrow more from other banks, increase their deposit base to use as a source of funding, or, horror of horrors, lend less. An increased cost of funds eats into profits. And lower lending levels definitely eat into profits. It is hard to build your art collection with lower profits.
–It’s no wonder Australian banks (and the Treasury) are resisting the G-20’s push to label Australia’s big four banks as “too big to fail.” This would require them to hold even more capital than already proposed. The Aussie banks assure us they are well-regulated and not at risk of causing a systemic crisis because they have lent prudently and have plenty of liquid capital. Got that?
–There are two forces at work here, then. One is the banks, who really want to go back to the good old days when they could borrow freely and loan liberally and not be constrained by capital and liquidity requirements. The other force is regulatory, which sees unlimited bank balance sheet growth (and low interest rates) as the sort of thing that can blow up a global economy (not desirable).
–What does any of this have to do with covered bonds? Funny you ask! That question came up yesterday over a beer with a friend. The conversation went something like this…
–“Come on, Dan. You’re not seriously arguing that an Australian bank is going to fail if the housing market crashes…and that the RBA is going to have to print money so the government can bail out depositors…are you? I mean, covered bonds wouldn’t cause all that, would they?”
–“No, that wasn’t my point.”
–“Well you should make your point, because it wasn’t very clear.”
–“Okay. My point was that Australia’s financial system looks a lot like all the other ones that got into trouble. Introducing loan guarantees…buying up residential mortgage-backed securities…allowing for covered bonds…and introducing the Financial Claims Scheme…all of it manages to accomplish one major result.”
–“Australian banks offload all of the risk from bad lending decisions to the taxpayer, via the government. The banks have every incentive to maximise profit because all the losses are going to be backstopped by the government. This isn’t capitalism at all. It’s what I called it yesterday, The Great Australian Bank Robbery, only the banks are robbing the people by forcing a set of regulatory changes that shift the risks on to the public.”
–“Oh. Well, you act like it’s a bad thing that banks are trying to find a way to funnel more money to the housing market. A lot of Australians own houses. The government and the banks should support the housing market or else a lot of people might lose a lot of money.”
–“That’s not capitalism either. That’s organised asset price inflation. And it’s just inflation. It’s not real wealth. Increasing a nation’s productive capacity (its capital stock) through investment produces real wealth. Trading houses between one another at higher and higher prices using more and more borrowed money is not wealth creation. It’s gambling. And it’s going to blow up.”
–“You’re such a buzz kill.”
–Apparently we are also a hatchet man, at least according to one reader:
Your little hatchet job on Garnaut was truly disgusting. A funny little lit wonk writing an investment blog has the arrogance to make fun of all reputable scientific advice and its mouthpiece, in this case, Garnaut. The American believer in you is capable of believing anything that comes to mind, and in this blog you don’t even have to justify yourself. I suppose you think the banning of CFCs to reverse the man made destruction of ozone in the atmosphere was also a plot by the ratbag scientists. Where will all this lead? Your article was a good example of pithy American believer nutterism. You are now on my ignore list.
–Well Ross, at least you got one thing right. Garnaut, as the government’s climate adviser, is little more than a mouthpiece for a predetermined position, and is probably being compensated for his efforts. His job is to produce a credible sounding and authoritative looking report that supports the government’s position, preferably filled with a lot of impressive jargon, bullet points, charts, and footnotes.
–But if you’re still reading, you should go back and read what we said again. Our criticism of Garnaut was that being an economist doesn’t make one a climate change expert. This is nothing more than an argument from authority, which is a tried-and-true logical fallacy. As an American nutter, our view is that authority can stick it in its ear.
–Being a doctor doesn’t make Garnaut right. Being in the majority doesn’t make him right. What would make him right is if he had a winning argument. If he wants to win the argument about climate change, he should stop treating the Australian public like a bunch of ignorant children who need to be told what to do.
–Yet this is what he said recently, according to the ABC:
There’s no doubt that there is a battle, an awful battle between ignorance and knowledge going on. It’s a great contest between the academies of sciences of Australia … the academies of science of all of the countries of scientific achievement on the one side, and the shock jocks of Australia on the other. We’ve had these battles before in the history of our civilisation. This battle will have quite a lot to do with the future prosperity of Australia, the future quality of our civilisation.
–Can’t you just smell the condescension in that statement? This is an indirect way of saying, “Don’t argue with me because I’m smart,” or its corollary, “You should shut up because you’re stupid.”
–But have a look at the key points in Garnaut’s latest update (number 8!) to his 2008 climate change report. This update is about nothing less than “Transforming the electricity sector.” In this report, Garnaut concludes that, “the introduction of a carbon price is highly unlikely to threaten physical energy security.” In other words, he’s saying it won’t put coal companies out of business. That’s disputable (although many would find it desirable), but he adds this bit:
Nevertheless, it may be prudent to implement cost effective policy measures to assuage concerns about energy security and to improve the regulatory functions of the energy market. These measures include
- The introduction of an Energy Security Council to implement measures to counter energy market instability regardless of the source; and
- The judicious provision of loan guarantees to high-emissions generators through the transition to carbon pricing.
–Did you get that? He doesn’t think his reforms will put the power industry out of business. Why? Because he’s going to form a committee with new powers to, you know, do things…and then have the government back-stop loans to keep newly unprofitable power companies from going out of business, if necessarry.
–Hmm. It seems like it would be easier to not introduce ‘reforms’ that could put Australia’s power companies out of business. But that would not be transformative. And the ultimate goal of the central planner and bureaucrat is to transform the nature of free markets so that everything flows through an elite bureaucracy of technocrats, of which Garnaut happens to be a high priest.
–But you have to give him credit. He does have faith. And strangely, he seems to have a lot of faith in the private sector to spontaneously generate technological improvements in response to a new carbon price introduced by the public sector. He says, “We need a lot of technological change, fast,” as if it’s like ordering, saying, a lot of fried chicken when you’re hungry.
–This seems like a fairly academic (and unrealistic) understanding of innovation; a kind of “just in time” technology change which eliminates all the negative effects of your policy change. What’s worse, Garnaut thinks that spending more money will magically produce the innovation required. Of course it’s government money (your money). He writes that:
One potential driver of accelerated technological development in low-emissions technology is the recent increase in public investment in innovation following the Great Crash of 2008. The injection of substantial ‘green’ stimulus spending by governments within stimulus packages following the Great Crash reversed the 35-year decline in real terms in low-emissions energy research, development and demonstration (IEA 2010) and raises the prospect of significant breakthroughs. This may extend beyond breakthroughs in learning by doing to shifts in technological processes or shifts in the production function.
–Translation, “Garble garble blah blah blah. Spend more public money on innovation and you’ll get the breakthroughs you need to make your policy workable or mitigate its wealth-destroying effects. Garble garble blah blah blah.”
–It’s important to point out that we’re not making an ad hominem attack on Garnaut the man. We’re merely raising two important points about how bad his ideas are. First, Garnaut has been selected as the point man on climate change to give credibility and authority to a report on a policy the government has already selected. There’s nothing objective about his ‘expert’ opinion.
–You might think of this as an argument, “From authority, with love.” He seems likable enough. And he is a doctor. He’s just the sort of guy to give covering fire to a government eager for more revenue and power over private and public life. But likable or not, the argument is from authority and for authority. And that should not be the basis of changing the cost of energy and the whole structure of production in the Australian economy.
–Our second important point is that Garnaut doesn’t know as much as he thinks he does. Neither do we. Neither do you. He’s only human in this regard. But perhaps he doesn’t recognise it. A bit of self-knowledge (and modesty) wouldn’t go amiss (yes , we aspire to this modesty as well).
–Specifically, he’s making the text-book economic mistake made by central planners and government bureaucrats. Like most people with a great faith in planning, he’s confident that his knowledge is complete and superior. But total knowledge in a complex and dynamic system is never possible. Friederich Hayek makes this point in his essay, The Use of Knowledge in Society (emphasis added is ours):
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources—if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.
–Hayek’s point, admittedly, is about planning in general, and prices. But the point remains: Garnaut is bulldozing through the climate change debate with pages and pages of predictions and prescriptions without complete knowledge of a) whether carbon dioxide is a pollutant, b) whether human beings are causing global warming, c) how the climate even changes over the long term.
–That is a lot of known unknowns. And it’s a lot of ambiguity to sweep under the rug as you make even more sweeping changes to Australia’s economy. But maybe we should just take his word for it and hope for the best. After all, with the government and a bunch of economists and academics in charge of the economy, what could possibly go wrong? You should shut up and do what you’re told.
For Markets and Money Australia